[Editor’s Note: The following originally appeared on FactSet.com. Elisabeth Kashner is director of ETF research and analytics for FactSet.]
Bloomberg Businessweek’s article “The ETF Tax Dodge Is Wall Street’s ‘Dirty Little Secret’“ provoked strong reactions, especially among ETF boosters.
Authors Zachary Mider, Rachel Evans, Carolina Wilson and Christopher Cannon informed a wide audience about the “heartbeat” trades that I first described in 2017. They documented the history and prevalence of heartbeat trades, quantified their dollar value, and identified banks that fund these ultra-short-term trades.
They also estimated the associated tax deferral amount for over 400 funds. Most importantly, the authors opened a discussion on the fairness of heartbeat trades, reminding readers that ETFs take advantage of a tax treatment that mutual funds seldom use.
Mider et al. collected industry opinion on the legal status of the trades. The detractors, some of whom are allied with the mutual fund industry, claimed heartbeats would be “vulnerable” to a challenge from the IRS because they are done "to facilitate the avoidance of tax."
Meanwhile, an advocate argued they improve the investor experience. Other industry users, including BlackRock, State Street, Vanguard Group, Bank of America, Credit Suisse Group and Goldman Sachs Group “either declined to comment on the trades or defended their use.”
The article also noted the Internal Revenue Service says it’s aware of heartbeats and wouldn’t comment on whether it considers them an abuse.
The accusations that heartbeat trades might sit on shaky ground with the IRS, and the reluctance of the trades’ major participants to publicly defend the practice, opened the door to much (heated) discussion about heartbeat trades’ fairness. The fund industry is having severe chest pains over the Mider et al. article.
Before anyone rushes to the emergency room, let's make sure we understand heartbeats' tax implications. It turns out heartbeat trades are a tax-deferral strategy, not a permanent tax dodge.
Investors incur capital gains tax liabilities in two ways: annual distributions and asset sales. Heartbeat trades eliminate annual distributions by deferring the liability until fund sale. They allow investors to postpone capital gains taxes.
Here’s how it works. Imagine a mutual fund and ETF have the same portfolios, and are managed identically. Each fund starts with $10.00 per share net asset value (NAV) and gains 10% per year. Each portfolio manager closes positions that generate $1.00 per share of profits each year. The mutual fund transacts directly in the securities market, while the ETF uses in-kind creations and redemptions.
The mutual fund must distribute its $1.00 of realized capital gains to its shareholders. The ETF makes no capital gains distributions; instead, it reinvests the sale proceeds.
Realized Vs. Unrealized Gains
At the end of the year, the mutual fund’s NAV is back at $10.00, and its investors have $1.00 in their pockets, which nets to $0.80 after tax (assuming a 20% capital gains tax rate). In contrast, the ETF year-end NAV rises to $11.00. ETF investors have netted $0.00, but have $1.00 of unrealized gains.
This repeats the next year, taking ETF NAVs to $12.10, pinning mutual fund’s NAV at $10.00, and distributing another $1.00 per share. This process continues for five years.
The disparity resolves when investors sell their positions.
Both the mutual fund and ETF investors owe taxes on their gains, which are the difference between purchase and sale prices. The mutual fund sale price will be lower than the ETF price, because of the annual reduction in the mutual fund’s net NAV. Meanwhile, ETF investors pay taxes on their compounded returns—a much higher sale price.
Over the full holding period, mutual fund and ETF tax bills will be identical. Mutual fund shareholders will have paid taxes every year, but avoided a large tax on sale, while ETF shareholders pay all taxes at the end.
The dollar amounts will be the same. But the mutual fund investors have paid sooner, thus losing out on the time value of taxes paid. The chart below shows NAVs and after-tax proceeds for this example:
For a larger view, please click on the image above.